The problem with (a shallow understanding of) models
You have been warned by t3rmin4t0r
Roger Martin, the dean of the Rotman School of Management, and author of The Opposable Mind, gave an insightful talk about the shortcomings of MBA programs today, and how to change them. One of the things he mentioned is how students tend to be taught a shallow understanding of models, and more often than not apply them blindly even when no longer valid. Not surprisingly, this can lead to catastrophic results.
He gives the example of the famous and widely used Black-Scholes options pricing model, whose inventors received the Nobel prize in economics for. What most people don’t realize is that the model, like all models, has stated limitations. It only applies to so-called European-style options, which can only be exercised at expiration, vs. American-style ones, which can be exercised at any time (and which make up the vast majority of options in the market). Furthermore, it also assumes non-dividend paying stocks, a stable interest rate, and of course efficient markets, among other things.
Just like the warning label on over-the-counter medication, these limitations are generally ignored, and this formula along with others like it are liberally applied every day to all manner of trades outside their limitations. The problem with a shallow understanding of a model is false confidence: Bankers confidently buy and sell shady derivatives thinking they are rock solid, and pass them on to an unquestioning public. Everything seems fine as long as circumstances don’t change too much, but they inevitably do, and everything comes down all at once.
It’s probably better to not to use a model at all, rather than blindly take it as gospel. At least this forces you to think harder about the risks you are taking.